Combining Reverse and Improvement 1031 Exchanges
Section 1031 of the Internal Revenue Code allows real estate investors to defer capital gains taxes by reinvesting proceeds from a property sale into new like-kind real estate. While the most common type is the forward exchange, investors with more complex goals may turn to advanced structures—namely the Reverse Exchange and the Improvement (or Build-to-Suit) Exchange.
In certain situations, these two strategies can even be combined to maximize flexibility. Here’s how it works.
Reverse 1031 Exchange Overview
A Reverse Exchange allows investors to acquire their replacement property before selling their relinquished property.
Because IRS rules prohibit the investor from owning both properties at once, an Exchange Accommodation Titleholder (EAT)—a special-purpose entity—holds either the old or new property temporarily.
Key features:
Buy first, sell later.
Maximum 180 days to complete the entire exchange.
Useful in competitive markets where finding the right replacement property quickly is essential.
Improvement 1031 Exchange Overview
An Improvement Exchange (also called a Build-to-Suit Exchange) allows an investor to use exchange funds to improve or construct a replacement property before taking ownership.
Key features:
Improvements must be made within the 180-day exchange window.
The EAT holds title while improvements are completed.
Only the value of completed improvements at the time of transfer counts toward exchange equity.
Combining the Two: Reverse + Improvement Exchange
In some transactions, investors need both strategies at once—for example, when the desired replacement property requires significant improvements or construction, but must be acquired before the old property is sold.
Here’s how a Reverse + Improvement Exchange works:
Acquisition by EAT
The EAT acquires and holds title to the replacement property on behalf of the investor.
Construction Period
During the 180-day exchange period, improvements are made using exchange funds.
Only improvements completed before the property is transferred to the investor count for 1031 purposes.
Disposition of Relinquished Property
The investor sells the relinquished property within the 180-day window.
Transfer of Improved Property
The EAT conveys the improved replacement property to the investor to complete the exchange.
Key IRS Guidelines
The governing guidance for these advanced exchanges comes primarily from:
Revenue Procedure 2000-37 (safe harbor for Reverse Exchanges).
Revenue Procedure 2004-51 (clarifications and modifications).
IRS rules impose strict timing requirements:
45 days to identify the relinquished property.
180 days to complete the exchange, including improvements.
Benefits of a Combined Strategy
Flexibility – Acquire replacement property first and tailor it with improvements.
Tax Efficiency – Defer capital gains tax while increasing the value of the replacement asset.
Strategic Advantage – Ideal for development projects, custom build-outs, or properties needing renovation before use.
Challenges to Consider
Tight Deadlines – Improvements must be completed within 180 days.
Financing Complexity – Coordinating funding between acquisition, construction, and exchange timelines can be demanding.
IRS Scrutiny – Proper documentation and adherence to safe harbor rules are essential.
Combining Reverse and Improvement Exchanges can be a powerful tool for investors with complex real estate strategies—especially when immediate acquisition and property enhancements are required. However, these transactions are among the most complex types of 1031 Exchanges, requiring precise structuring, experienced intermediaries, and close consultation with tax and legal advisors.
When executed correctly, this combined strategy provides investors with the ultimate flexibility: the ability to buy first, build or improve, and still achieve full tax deferral under Section 1031.
